Court of Appeal clarifies the test for insolvency: implications for contracts and creditors

This article was produced by Olswang LLP, which joined with CMS on 1 May 2017.

The Court of Appeal has recently considered the "balance sheet test" used to determine whether a company is insolvent by being unable to pay its debts under section 123(2) Insolvency Act 1986 ("IA 1986"). The decision will affect creditors applying for winding up orders and parties to finance documents and commercial agreements which contain events of default or termination provisions based on the section 123(2) IA 1986 balance sheet insolvency test.

Court of Appeal decision and implications

The Court of Appeal has upheld the decision of the High Court in the case of BNY Corporate Trustee Services Ltd v Eurosail UK 2007-3BL PLC & Ors and held that the balance sheet insolvency test cannot be simplified into a single formula that applies to all. To establish if a company is balance sheet insolvent, the court has to form its own view in determining whether the company has 'reached a point of no return because of an incurable deficiency in its assets'[1].

The practical implications of the decision mean that it will be more difficult for creditors to obtain winding up orders against companies on the basis that they are balance sheet insolvent and accordingly, it is likely that the courts will grant fewer winding up orders on this basis. The uncertainties introduced into the test will also mean that parties to finance documents and commercial agreements are likely to find it more difficult to rely on events of default and termination provisions based on a specific reference to section 123(2) IA 1986 and this will need to be considered when agreements are drafted and negotiated.

Determining whether a company is insolvent on a balance sheet basis

Insolvency is not defined in the IA 1986, although the two generally accepted tests used to determine whether a company is insolvent are the cashflow test under section 123(1)(e) IA 1986 (i.e. where a company is unable to pay its debts as they fall due), and the balance sheet test under section 123(2) IA 1986 (i.e. where a company's assets are exceeded by its liabilities, taking into account its contingent and prospective liabilities). This case looked at the balance sheet test and the court held that section 123(2) did not turn simply on the question whether the liabilities of the company exceeded its assets. Rather, the section was intended to cover a case where, although it could not be said that a company was currently unable to pay its debts as they fell due, it was, in practical terms, clear that it would not be able to meet its future or contingent liabilities.

The Eurosail decision is a very pragmatic and, in our view, sensible approach as to how to interpret the balance sheet test and avoid technical insolvencies. The judges in the case stipulated that whilst a company's most recently audited accounts could form a suitable starting point for the balance sheet valuation exercise, it must be shown that the company has reached 'the point of no return', i.e. that allowing the company to continue to operate and pay its short term liabilities would simply reduce the overall pool of assets available to pay the company's future and contingent creditors. To show this, other factors besides the recently audited accounts of that company must be examined.

The following factors should be considered in determining balance sheet insolvency:

• The requirement under section 123(2) IA 1986 to take into account contingent and prospective liabilities in the balance sheet test does not mean that such liabilities should automatically be attributed their face value. For example, the closer a liability is to mature, or the more likely the contingency which would activate a contingent liability, and the greater the size of the likely liability, the more probable it would be that section 123(2) IA 1986 would apply to it. In Eurosail, the company had a long forward looking period. There were notes with a final redemption date of 2045, and the average underlying mortgage term was around 18 years, meaning that these liabilities were given less weight in the test than they had on the balance sheet.

• Just because one set of creditors would be better off if a company was wound up immediately rather than being permitted to carry on business, should not alone be sufficient proof of the company's inability to pay its debts as they fall due.

• Sums that are to be recovered from ongoing litigation may also be considered an asset even though this is not a traditional viewpoint from an accountancy perspective. (Eurosail had an ongoing claim of $221 million against Lehman Brothers that the judge decided should not be ignored in their balance sheet test.)

• The balance sheet test under section 123(2) IA 1986 is not entirely independent from the cash flow test referred to above, and the combination of both should contribute to determining whether a company has reached the 'point of no return'.

Commentary

The overall message from this case is that the court will not give a set calculation test by which to establish balance sheet insolvency, and such a decision should be determined with a firm eye on commercial reality and fairness. The onus on the requirement to show clear evidence that a company has reached the end of the road gives the impression that this will become harder to prove, a point that is reinforced by the court noting that whilst there would still be such cases, they would be comparatively rare.

[1] Goode, Principles of Corporate Insolvency Law, 2005, Sweet & Maxwell

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Any information contained in this article is intended as a general review of the subjects featured and detailed specialist advice should always be taken before taking or refraining from taking any action. If you would like to discuss any of the issues raised in this article, please get in touch with your usual Olswang contact. This article was included in our Olswang Corporate Quarterly Summer 2011 publication.